Morningstar Advisor - December/January 2012 - (Page 26)

In Practice About Morningstar Investment Services Morningstar Investment Services brings fee-based advisors the resources of an independent, experienced investment team. The team’s range of customizable stock, ETF, and mutual fund portfolios is guided by proprietary methodologies and leverages the well-recognized research of Morningstar, Inc. For more information, visit http://global. morningstar.com/mis or call +1 877 751-4208. pumped around $45 billion into actively managed large-cap funds, relatively few of which had topped the S&P in the preceding years. Yet, one obvious and crucial difference is the market’s trajectory— sharply higher then, flat to lower in recent years. Put another way, it’s a lot easier for investors to forgive a manager for gaining 19% when the market’s up 20% than to give that same fund a pass when it’s down 30% versus a 28% loss for the S&P. Loss aversion is powerful in explaining behavior. Investor behavior likely also plays a role in explaining the influence of other, more-nuanced factors in investor attitudes toward active management. For example, active management’s quest to top the markets has long evoked the possible. Those possibilities seem all the brighter at times when active managers can be seen smashing their benchmarks. But that was a much more common sight a decade or so ago than recently, as shown in Exhibit 2, which plots the excess returns of large-cap managers at various percentiles. As the chart makes plain, the excess returns at one and two standard deviations were significantly larger in the past. As excess returns have narrowed, it’s likely that the possibility—that is, the payoff— of active management has dimmed in some investors’ eyes, raising questions about its usefulness. One other factor is the way we measure active management—beat rates and margins of outperformance can be exaggerated. Why? The most common method of measuring active-manager success is using funds’ most-recent category classification. The problem is that funds change categories from time to time, potentially making such comparisons potentially imprecise. To illustrate, we compared beat rates calculated under our approach (which accounts for any category changes from one rolling period to the next) with one that considers the most-recent categorization only. As shown in Exhibit 3, the difference is meaningful: Under the “most-recent” method, 52% of active managers appear to beat the S&P, on average, in a given three-year period, versus the 46% beat rate we’d previously calculated. What’s more, the average excess return was 0.54% higher under the “most-recent” method. These differences arise for two reasons. First, funds leave a better-performing area to join the new peer group, as in the case of mid-cap funds that became large-cap funds in recent years. In these cases, these managers appear to have “beaten” the S&P over many of the rolling periods examined when, in fact, that outperformance is less a matter of skill than style or risk-taking. Second, underperforming funds aren’t captured in the peer group, either because they switched to a different category or were mothballed in earlier periods. Why does it matter? Disappointment with active management is partly a function of expectations, which the “most-recent” method raises to a potentially unattainable extent. This, in turn, can feed the same emotions that have spurred investors to leave active management for greener pastures. The Grass Is Greener? many of these funds roared back during the recovery, large-cap managers in particular. The rejoinder, of course, is that it’s the magnitude of outperformance that really counts—beating the benchmark by a trivial amount counts only as a moral victory, if that. But when we examine the trend in median rolling excess returns, there are few signs that active management has slumped to an unusual extent, at least not when compared with history. Though relative performance has slipped in recent months, large-cap managers have generally kept pace with, if slightly surpassed, the S&P 500 in most rolling 36-month periods since the depths of the financial crisis. What’s more, the median excess return has been slightly higher than the historical norm in the majority of rolling periods since 2006, a period that’s seen redemptions accelerate. The Crux of the Problem One can quarrel with active management for a number of reasons, not least its cost, but active investing appears not to have been any more futile (or, if one prefers, less successful) in recent years than the historical average. So, what’s got investors so bent out of shape? They haven’t always been so punitive. Take the year 2000, for instance, when investors Today’s investors are clearly better attuned to the importance of costs and diversification. They’re placing a premium of importance on portfolio construction and transparency and the market has shifted away from the “closed” distribution model that formerly stacked the deck in favor of actively managed funds. In general, these developments are likely to further cement demand for passively managed strategies. Nevertheless, the recent flight from actively managed equity funds raises questions of whether investors, in their zeal for passive management, have made a fully measured assessment of active managers’ performance. As our research has shown, active management has been no less successful in recent years than the historic 26 Morningstar Advisor December/January 2012 http://global.morningstar.com/mis http://global.morningstar.com/mis

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Contents
Contributors
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012